Download Financial Stability, Regulatory Buffers, and Economic Growth

Working Paper No. 637
Financial Stability, Regulatory Buffers, and Economic Growth:
Some Postrecession Regulatory Implications
by
Éric Tymoigne*
Levy Economics Institute of Bard College
November 2010
* The author thanks Charles Whalen for his comments and edits.
The Levy Economics Institute Working Paper Collection presents research in progress by
Levy Institute scholars and conference participants. The purpose of the series is to
disseminate ideas to and elicit comments from academics and professionals.
Levy Economics Institute of Bard College, founded in 1986, is a nonprofit,
nonpartisan, independently funded research organization devoted to public service.
Through scholarship and economic research it generates viable, effective public policy
responses to important economic problems that profoundly affect the quality of life in
the United States and abroad.
Levy Economics Institute
P.O. Box 5000
Annandale-on-Hudson, NY 12504-5000
http://www.levyinstitute.org
Copyright © Levy Economics Institute 2010 All rights reserved
ABSTRACT
Over the past 40 years, regulatory reforms have been undertaken on the assumption that markets
are efficient and self-corrective, crises are random events that are unpreventable, the purpose of
an economic system is to grow, and economic growth necessarily improves well-being. This
narrow framework of discussion has important implications for what is expected from financial
regulation, and for its implementation. Indeed, the goal becomes developing a regulatory
structure that minimizes the impact on economic growth while also providing high-enough
buffers against shocks. In addition, given the overarching importance of economic growth,
economic variables like profits, net worth, and low default rates have been core indicators of the
financial health of banking institutions.
This paper argues that the framework within which financial reforms have been discussed
is not appropriate to promoting financial stability. Improving capital and liquidity buffers will
not advance economic stability, and measures of profitability and delinquency are of limited use
to detect problems early. The paper lays out an alternative regulatory framework and proposes a
fundamental shift in the way financial regulation is performed, similar to what occurred after the
Great Depression. It is argued that crises are not random, and that their magnitude can be greatly
limited by specific pro-active policies. These policies would focus on understanding what Ponzi
finance is, making a difference between collateral-based and income-based Ponzi finance,
detecting Ponzi finance, managing financial innovations, decreasing competitions in the banking
industry, ending too-big-to-fail, and deemphasizing economic growth as the overarching goal of
an economic system. This fundamental change in regulatory and supervisory practices would
lead to very different ways in which to check the health of our financial institutions while
promoting a more sustainable economic system from both a financial and a socio-ecological
point of view.
Keywords: Financial Crisis; Financial Regulation; Banking Supervision; Sustainability
JEL Classifications: E12, E58, G18, G28, Q01
1
INTRODUCTION
The three decades preceding the Great Recession were marked by a strong return of free-market
ideas around the world. Those ideas justified an extended period of financial deregulation that
peaked around the year 2000 in the United States (1999 Financial Modernization Act, 2000
Commodity Futures Modernization Act, and the 2000 amendments to the Employee Retirement
Income Security Act) and in 2005 at the international level (Basel II Accord). Risk management,
self-regulation, and market discipline became central financial-sector “pillars” that ought to be
promoted and applied to as many institutions and countries as possible. According to the era’s
guiding philosophy, there was to be minimal government regulation, supervision, and
enforcement. The overriding goal of regulators was to avoid limiting the creativity of financial
institutions, creativity that was seen as vital to economic competitiveness.
The Great Recession shattered the core foundations of that view. Risk management
techniques encouraged unsound financial schemes involving massive leverage; self-regulation
led to loose, hazardous and even fraudulent business practices; and market discipline meant an
emphasis on short-term profitability and a “race to the bottom” in terms of lending standards.
The end result was so disastrous that even prominent free-market advocates, including Former
Federal Reserve Chairman Alan Greenspan, expressed disbelief and conceded that their
ideological framework had failed. At Congressional hearings, officials from the US Securities
and Exchange Commission and other regulatory institutions were publicly humiliated for failing
to detect signals of an impending crisis, and further inquiries revealed extraordinarily lax
supervisory practices (US Senate 2009a, 2009b).
Given that such a disastrous regulatory and supervisory failure occurred, one may wonder
why there has not been a radical change in the way we approach the regulation of financial
institutions. Instead, discussion has aimed primarily at improving the existing regulatory
framework. Thus, the focus has been on introducing liquidity requirements and flexible capital
requirements, on mandating maximum leverage ratios, and on increasing the size of common
equity (Basel Committee on Banking Supervision 2010). These reforms are supposed to yield the
highest sustainable growth rate and simultaneously provide adequate protections against future
financial crises. However, the core problem is that the entire analytical framework underlying
2
this approach has failed. The heart of the matter is not that the mathematical models failed to
recognize the economic risks, it is that the underlying economic principles also failed.
This chapter argues that a much more radical reform of financial regulation is needed to
account for the intrinsic instability of market economies. It also argues that promoting financial
stability may not be enough and that it may be necessary to change the management of our
economic affairs in order to achieve broad sustainability. The first section briefly surveys the
foundations of the current regulatory system. The second section critically assesses the popular
position that improving capital and liquidity requirements is the solution to our current problems.
The third section outlines an alternative approach to financial regulation.
FOUNDATIONS OF THE CURRENT SYSTEM
The current regulatory system rests on a particular understanding of financial crises and a
specific view of the central goal of an economic system. These conceptions complement each
other to create a coherent policy vision in which the economic goal is to maximize economic
growth, while the regulatory goal is to provide the least intrusive oversight, but also a high
enough financial buffer in the event of financial problems.
Efficient Markets and Sophisticated Participants
According to the viewpoint underlying the current regulatory system, market mechanisms have
an inherent ability to promote stability, respond to the wants of the population, and correct for
misallocations of resources. From that perspective, markets are not prone to financial instability
and resource misallocation. Adair Turner, chair of the UK Financial Services Authority (FSA),
explained this mindset in a recent speech:
In the past, in the years running up to the crisis, it was the strong
mindset of the FSA—shared with securities and prudential
regulators and central banks across the world, it was almost part
of our DNA—that we assumed that financial innovation was
always beneficial, that more trading and more liquidity creation
was always valuable, that ever more complex products were by
definition beneficial because they completed more markets,
allowing a more precise matching of instruments to investor
demand for liquidity, risk and return combinations. And that
mindset did affect our approach—and the approach of the whole
3
world regulatory community—to the setting of capital
requirements on trading activity; it affected our willingness to
demand risk reduction in the CDS [credit default swaps] market;
and it influenced the degree to which we could even consider
short-selling bans in conditions of exceptional market
volatility.…[Stepping out of that mindset] poses for regulators
the challenge of complexity, because it involves rejecting an
intellectually elegant but also profoundly mistaken faith in ever
perfect and self-equilibrating markets, ever rational human
behaviors. (Turner 2009)
This free-market approach to economic affairs has three consequences. First, it suggests
that financial crises are rare events induced by specific types of imperfections. A major category
of imperfections is associated with the difficulty of establishing pure and perfect competition,
which requires atomicity, transparency, homogeneity, perfect mobility, and free entry/exit. In
most discussions of this difficulty, emphasis is usually placed on the lack of transparency—on
asymmetry of information between lenders and borrowers as a source of instability (Mishkin
1991). However, the lack of homogeneity of some financial products has also recently received
much attention for preventing market mechanisms from working properly (credit default swaps
are an example). Another class of imperfections includes not only overconfidence and other
“biases” studied in behavioral finance, but also the limited cognitive capacities studied by
Herbert Simons. Government intervention is still another type of imperfection. The argument is
that government promotes inefficiency and instability through discretionary fiscal and monetary
policies, programs that allocate resources to particular economic units at preferential terms, and
regulations that suppress financial innovations and waste resources (Taylor 2009). In the end, if
incentives are set properly and market participants are taught how to respond to incentive
properly, market mechanisms will promote stability and efficiency.
Second, the free-market approach argues that an effective way to promote financial
stability is to aim for perfect competition. This can be done by improving the transparency of
information in financial markets, which would give participants a better understanding of
economic risks and improve market signals. For example, greater transparency could be achieved
by creating new financial indices or improving existing ones. Aiming for perfect competition can
also include supporting “fundamentals-oriented” financial education, which proponents see as a
way to help market participants make better-informed decisions (Shiller 2000). This aim can also
4
be pursued through the use of stock options and other compensation mechanisms that link the
pay of managers and employees to the performance of their business.
Third, the free-market approach calls for protection against random shocks that may
affect the system and create financial difficulties. This can be done by putting in place capital,
liquidity, and loan-loss reserve requirements to provide buffers against unexpected and expected
losses. Ideally, however, the adequacy of these buffers should not be determined by regulators,
they should be market determined. After all, according to this viewpoint, financial-market
participants know their line of business better than regulators and have an incentive to preserve
their business as a going concern. Thus, with the help of market signals, bankers are the most
qualified to calculate the appropriate buffers against potential financial problems given existing
risks. This is the essence of the thinking behind Basel II, now being amended by Basel III.
The idea that business managers and other market participants know best—and would not
implement decisions harmful to themselves and the economy—has been pushed forward by the
US Treasury even during the Great Recession: “Treasury believes market participants will be
reluctant to self-certify rules harmful to the market place” (Department of the Treasury 2008:
116). Thus, while Turner hints at a change in the mindset among regulators and Greenspan
admits to a flaw in his laissez-faire philosophy, one has reason to doubt that there has been a real
shift in thinking among business leaders, bankers, and policymakers. Perhaps the best recent
evidence of this is the lack of fundamental regulatory reform analogous to that seen in the 1930s.
Growth and Investment as Overriding Economic Priorities
The free-market view of financial crises and how to prevent and protect against them is
complemented by a specific conception of the primary goal of an economic system. The goal is
not social provisioning; it is to achieve economic growth, and to constantly create and satisfy
new wants. Thus, economic growth must be preserved for its own sake, and this affects how the
financial system is regulated and supervised. Indeed, the goal becomes to regulate in such a way
that economic growth is minimally impaired, and, if possible, promoted. This was reemphasized
recently by U.S. Treasury Secretary Timothy Geithner (2010) after the passage of the DoddFrank financial legislation: “The reforms that are now the law of the land will help us rebuild a
pro-growth, pro-investment financial system.”
5
As shown below, the emphasis on economic growth leads regulators to focus on specific
indicators of financial health to guide their supervisory actions, but those indicators are not
effective at identifying financial fragility. In addition, whenever regulatory actions are proposed
to restrain innovations in financial practices, opponents argue that such regulations would lead to
a decline in economic growth. Given that economic growth is considered sacred, an argument
tying financial innovation to growth is usually powerful enough to delay or even reverse a
regulatory action. This is especially so after a long period of stability, when regulations are
widely seen as burdensome and irrelevant because there has not been any recent crisis. And all
this is reinforced by the associated argument that individuals and businesses will not be able to
thrive—and will, in fact, be prevented from leading a better life—in an economy that restricts
financial activities. A recent example illustrates this point.
In December 2005, five federal regulatory agencies proposed to issue a so-called
“guidance” in response to their concern about innovations in the subprime mortgage sector. A
guidance is not a law, but a statement to guide the priorities of in-field supervisors. It also
provides financial institutions with an idea of what to expect from supervisors. The proposed
guidance stated that financial institutions should carefully underwrite subprime mortgages by
qualifying people on the basis of the full debt-service payment (instead of the initial interest
payments) and by verifying income, assets, and employment. All these are reasonable demands
that deal with practices that have proven toxic since the earliest days of banking.
The guidance was submitted to the industry for comments and received a barrage of
criticisms. One argument against the guidance was that low default rates on mortgages proved
the reliability of the mortgage practices and that there was no need to constrain them; stability
“proves” markets are stable and regulation is an unnecessary burden. Opponents also argued the
guidance would deny “good people” access to the American Dream and reduce the
competitiveness and flexibility of the U.S. financial system. Here is a typical statement by an
industry spokesperson, in this case George Hanzimanolis, president-elect of the National
Association of Mortgage Brokers, testifying on the proposal at a Senate hearing:
Many innovative loan products, such as the interest-only ARM
[adjustable-rate mortgage] or the 40-year mortgage, have
contributed to the greater availability of diverse loan products
and enhanced consumer choice, which has directly resulted in
increased competition and more affordable credit….
6
[I]nnovation and technological advancement in the mortgage
marketplace has occurred because the market has been free to
identify market needs and develop loan products to satisfy that
need. Government regulation of this innovative spirit, whether in
the area of pricing, compensation, or in product development,
will only result in firm boundaries that will prevent the
marketplace from adequately responding to consumer needs in
the future.… The bottom line is that unwarranted tightening of
underwriting guidelines could hurt the robust housing industry
and deny deserving consumers the chance at homeownership.
(Hanzimanolis 2006)
As a result of such opposition, the guidance was not implemented until June 2007. By
that time, there were no more profits to be made on subprime mortgages and the guidance no
longer mattered to the financial industry (Office of the Comptroller of the Currency et al. 2007).
In addition, the guidance was limited to subprime lending even though the same practices were
also associated with prime lending (Tymoigne 2009c).
A similar story can be told about leaving credit default swaps unregulated or allowing
pension funds to buy dangerous securitized products. And the opposition’s arguments were the
same: the regulation of innovation constrains economic growth, profitability, societal well-being,
and even national competitiveness.1 These arguments were all the more compelling because
many people benefitted from continuation of business as usual, regardless of the growing danger
of financial fragility and the fleeting nature of the access to the American Dream.
Capital Buffers and Economic Stability
This section assesses the capacity of capital and liquidity buffers to promote financial stability.
In the wake of the recent global financial crisis, it is often argued that greater financial stability
can be achieved by the introduction of capital and liquidity buffers that are larger and better (in
1
An aversion to financial regulation is found not just within the financial industry. Consider the following from a
2008 U.S. Treasury Department document, for example:
The business conduct regulator should not have the ability to broadly prohibit
products, limit entry through excessive licensing requirements, or control prices.
In general, business conduct requirements that are too rigid can result in less
competition, less innovation, and diminished flexibility to adapt to market
conditions. For example, broad prohibitions on products should only be
considered in circumstances where disclosures and regulation of business
practices prove insufficient. (Department of the Treasury 2008: 171)
7
the sense of capturing risks more accurately) than in the past. In fact, however, no matter how
buffers are improved, they will not promote financial stability. And they will give regulators an
inaccurate indication of the economic system’s financial health.
Capital and liquidity buffers in place during a financial crisis are usually too small to
provide an adequate protection. This is so not only because available buffers are too small but
also because the regulatory buffers are set too low to provide a good protection against
significant financial difficulties. In addition, merely putting in place buffers does not prevent
financial fragility from growing and may not lower moral hazard and risk taking.
Long Period of Stability and Inadequate Buffers
Significant financial crises are almost always preceded by a long period of economic stability
during which financial institutions lower their credit standards (as explained in Tymoigne
[2009a]), which decreases the effective protection provided by a given buffer. Today, despite the
recent crisis, several bankers argue that their less restrictive lending standards were necessary for
business survival in a competitive environment. Blankfein, CEO of Goldman Sachs, stated: “I
regret that we participated in transactions that brought too much leverage into the world…. But
those were the standards of the moment” (Blankfein in Vikraman and Nair 2010). Previously, he
made very similar comments: “We rationalized and justified the downward pricing of risk…. We
did so because our self-interest in preserving and extending our market share, as competitors,
sometimes blinds us—especially when exuberance is at its peak” (Blankfein 2009).
Charles O. Prince III, former CEO of Citibank, recognized that his bank was involved in
dangerous financial practices that contributed significantly to the crisis. In his view, the bank was
merely responding to the demands of hedge funds, institutional investors, and private equity
funds, which were seeking high returns through leveraged buy-outs and exotic mortgage-related
deals. And he believed its practices were justified: “When the music stops, in terms of liquidity,
things will be complicated. But as long as the music is playing, you’ve got to get up and dance.
We’re still dancing” (Prince in Nakamoto and Wighton 2007). John Maynard Keynes (1936:
157) understood this phenomenon. More than 80 years ago, he wrote: “Worldly wisdom teaches
that it is better for reputation to fail conventionally than to succeed unconventionally.”
As the effectiveness of a given level of buffers decline because of the increase riskiness
of financial deals (in terms of assets and liabilities), institutions also have an incentive to lower
8
the available buffers. Indeed, a long period of stability means that default rate will be low,
profitability will be high, and other financial information will be positive. Thus, a long period of
stability will lead to lower financial buffers, not necessarily because of irrationality and other
“biases,” but simply because the economy is performing better. Moreover, over a long period of
stability, this tendency is all the more pervasive since the data used in the calculation of
necessary buffers rarely looks back beyond two years, thus excluding financial crises (Gallati
2003: 362). In addition, bankers make predictions over a limited time horizon, typically one year
for credit risk and only a few days or months for portfolio value at risk (Gallati 2003: 146,
371ff., 384). The result is buffers appropriate for only minor financial problems. This problem is
reinforced by the fact that predictions are backward looking rather than forward looking and so
failed to account for the implication of increasing risk taking on the asset and liability sides of
balance sheets. Recently, all these dynamics have led to a very low level of loan-loss reserve not
seen since 1985, even though the quality of loans declined dramatically (Best 2007).
Profitability and Required Buffers
The capital and liquidity needed to deal with a significant financial crisis is more than financial
institutions find economically attractive. This has been acknowledged by the financial industry’s
Counterparty Risk Management Policy Group:
To some extent…all risk management tools are unable to
model/present the most severe forms of financial shocks in a
fashion that is credible to senior management….To the extent
that users of stress tests consider these assumptions to be
unrealistic, too onerous, …incorporating unlikely correlations or
having similar issues which detract from their credibility, the
stress tests can be dismissed by the target audience and its
informational content thereby lost. (Counterparty Risk
Management Policy Group III 2008: 70, 84)
A proper determination of the adequate buffer would consider events like the Great
Depression and the Great Recession even decades after their occurrence, but the results would be
unacceptable to the financial industry. That means the capacity of a capital buffer to absorb
significant problems is limited from the start. Moreover, a long period of stability dims the
9
memory of past crises at the same time that it intensifies competition and thereby erodes sources
of profitability.
The Persistence of Financial Fragility: ROE and Financial Innovations
If one assumes that adequate buffers could be set, this would not prevent the development of
financial fragility. From the point of view of the current regulatory system, merely applying
buffers makes sense because financial crises are random, rare events. However, if one considers
that financial crises are not random in the sense that the conditions for their occurrence are
progressively laid out during a period of stability, then it makes sense to do more than provide
buffers. The latter are necessary, but they are only a last and limited line of defense. By taking
preventive actions, it is possible to avoid some situations in which using those buffers becomes
necessary.
A good way to see why buffers are not enough is to study the return on equity (profit
divided by equity). The latter can be decomposed into its two components: the rate of return on
assets (profits divided by assets) and the leverage ratio (assets divided by equity).
As an economic expansion proceeds, the rate of return on equity tends to decline because
profit is added to equity and the growth rate of profit tends to decline over time as markets
saturate.2 Thus, economic prosperity creates tensions that promote instability. To counter a
decline in the return on equity, financial institutions can increase their return on assets or their
leverage. Improving the return on assets involves creating new markets or expanding existing
2
More formally, the Π/E = Π/A x A/E and ROEt = Πt/Et with Et = Et-1 + Πt-1 and Πt = Πt-1(1 + g). Knowing this, one
can compute the dynamics of ROE and given the growth rate of profit (g = g0):
Therefore:
If ROE0 = g0 then ROEt = g0 ∀t. If ROE is smaller (bigger) than the growth rate of profit, ROE goes up (down).
Overall, the actual dynamics of ROE over time depends on the value of ROE relative to the growth rate of profit and
on the evolution of the growth rate of profit. However, as markets saturate the growth rate of profit declines and so
the steady-state value of ROE declines, too. In addition, in new markets ROE is probably greater than g so ROE
goes down over time to its steady-state value, which itself declines overtime.
10
markets by moving toward more risky endeavors in terms of creditworthiness, liquidity, and
funding sources. Increasing leverage (given existing asset quality, funding sources, and
regulatory requirements) also involves financial innovations in order to bypass leverage limits
that regulators impose.3
In short, even if some constraints are put on the leverage ratio and asset quality, unless
innovations are regulated, the constraints are bypassed because financial institutions must find
ways to maintain their return on equity. As Campbell and Minsky write:
To the extent that the examination procedure lags rather than
anticipates financial innovation, higher insurance premiums [and
capital requirements] on what examiners take to be riskier
institutions may not be a deterrent to risk-taking. In an
expanding economy, the increased cost of doing business caused
by higher deposit insurance premiums [and capital requirements]
will be an incentive for banks to invent new, unregulated forms
of financing. (Campbell and Minsky 1987: 258)
Financial institutions do not have a choice; market mechanisms compel them to find
techniques that counter the tendency of the return on equity to decline over time during an
expansion. This pressure to lower underwriting criteria, engage in high-stakes activities, and
increase leverage is compounded by the fact that institutions (and their investors) have in mind
some targeted return on equity and competition among financial institutions can be expected to
be strong. As a consequence, it is not difficult to see how financial fragility can emerge over a
period of economic stability and why bank executives defend their actions in the way illustrated
above.
3
A recent article shows that regulatory arbitrage is already at play following the US regulatory reforms enacted in
the summer of 2010 (Jenkins and Masters 2010). Given the high cost of capital in the regulated financial industry,
financial institutions have started to move further away from traditional banking, and some nonfinancial institutions
are getting even more involved in financial activities. Regulated financial institution have been created their own
hedge funds and private equity funds, and “oil companies such as Total and BP and traders including Cargill and
Vitol are in effect shadow banks for the commodities industry, replicating the services that the likes of Goldman
Sachs and Morgan Stanley monopolised for years.”
11
Risk-Taking and Capital Buffer
Although a major argument for better and higher capital requirements is that they would limit the
moral hazard and thus reduce risk-taking activities, this is not necessarily so. Having some “skin
in the game” may not prevent financial institutions from taking massive risks. In fact, quite the
opposite might happen: a “large” buffer might foster more risk taking by providing a greater
sense of security and by fueling the return on equity mechanics described above (Kregel 2006;
Wray 2006).4
The recent crisis shows that unexpected results of this sort do indeed occur. Greenspan
acknowledges he was baffled by what happened: “I made a mistake in presuming that the selfinterest of organizations, specifically banks and others… [was] best capable of protecting their
own shareholders and their equity in the firms” (Greenspan in U.S. House of Representatives
2008: 34). Toward the end of the S&Ls crisis, James B. Thomson (1991), of the Federal Reserve
Bank of Cleveland, concluded that “book solvency is positively related to failure” and he noted
that: “One possible explanation is that banks beginning to experience difficulties improve their
capital positions cosmetically by selling assets on which they have capital gains and by deferring
sales of assets on which they have capital losses” (Thomson 1991: 13). This is typical of Ponzi
finance as explained below.
Although it runs counter to the current regulatory and supervisory approach of banking,
the conclusion generated by the preceding discussion is that regulators should not wait for
declining profitability, declining net worth, or other signs of payment difficulties to take strong
actions. That conclusion is also consistent with recent US economic experience. For example,
most of the companies involved in highly dangerous financial activities during the housing boom
recorded large profits and a high credit rating, and were able to meet their capital requirements;
they were deemed healthy when they were, in fact, very fragile. The same is true for households,
which were said to be in good shape (Greenspan 2004) when their increases in net worth were
actually based on weak financial positions. Thus, the gains they accumulated since 2003
disappeared with the housing-market collapse and financial crisis (Tymoigne 2010). There were
also no profitability or payment difficulties before the savings and loan crisis, even though the
4
In other words, a higher level of capital may give a false sense of protection and boost optimism, and a higher
capital ratio depresses the return on equity, which gives an incentive to search for higher return on assets and boost
leverage on any excess capital.
12
most profitable thrifts were involved in massive, unsustainable, and fraudulent financing in
commercial real estate (Black 2005).
Strict underwriting requirements would be much more effective at promoting financial
stability than buffers. Because asset values are prone to fluctuating, collateral-based lending is
highly prone to instability and is exceedingly hard, if not impossible, to buffer properly (Suzuki
2005; Knutsen and Lie 2002). Meanwhile, financial fragility may grow long before losses
materialize and capital and liquidity buffers decline. And when loses do materialize, years of bad
underwriting may make the losses so large that buffers are woefully inadequate. Even worse, the
entire economic system is at risk when growing financial fragility has served as the foundation
for widespread profitability and economic growth.
Alternative Regulatory Reform
An alternative regulatory framework starts by recognizing that financial crises are created during
periods of stable prosperity that recorded only minor recessions. Such crises are not random, rare
events that can be addressed only by means of defensive protections. Financial instability, rather
than market efficiency, is the inherent result of a market economy performing well for a
relatively long period of time. Buffers may help to contain a problem, but they are of limited
usefulness when the aim is to prevent crises and maintain financial stability. And asking
financial-market participants to determine those buffers is destined to fail because their incentive
is to preserve growth and their main indicators of financial health are increasing profits and a
high return on equity. This alternative framework also notes that, rather than putting investment
and economic growth on a pedestal, the regulatory system should be tilted toward promoting
financial and economic sustainability.
The Financial Instability Hypothesis
Minsky (1986) provides a framework for understanding and measuring how financial fragility
develops. He distinguishes between three types of financial position: hedge, speculative, and
Ponzi.
Hedge finance means an economic unit is expected to be able to pay its liability
commitments with the net cash flow generated from its routine economic operations (such
operations entail work for most households and production and sale of goods and services for
13
most companies). Thus, even though indebtedness may be high, an economy in which most
economic units rely on hedge finance will not experience a debt deflation (that is, a severe
financial and economic crisis) unless there are unusually large declines in routine cash inflows
and/or unusually large increases in cash outflows. Even then, cash reserves and liquid assets are
usually large enough to cope with unforeseen problems.
Speculative finance means routine net cash flow sources and cash reserves are expected
to be too low to pay the capital component of liabilities. In other words, an economic unit
engaged in speculative finance would not be able to make principal payments or meet margin
calls on the basis of its routine operations. As a consequence, such a unit needs either to borrow
funds or to sell some less-liquid assets to pay part of liability commitments.
Ponzi finance means an economic unit has neither the cash reserves nor the ability to
generate net cash flow from its routine economic operations to meet the capital and income
service due on outstanding financial contracts. If a majority of economic units is involved in
Ponzi finance, the economic system is highly prone to debt deflation. According to Minsky’s
financial instability hypothesis (Minsky 1986), when an economy is stable and performs well
over an extended period of time, more and more economic units move away from hedge finance
and become involved in Ponzi finance.5
As illustrated during the recent housing boom, Ponzi processes (economic activities
sustained by Ponzi finance) do not need to be masterminded by a single individual or a small
group of individuals. Rather, they may be sustained and approved by the entire society because,
in the short run, they may raise standards of living and promote economic growth, employment,
and competitiveness. In any case, those already in the Ponzi process have an incentive to
promote an optimistic view of the future and entice others to participate. And the attractiveness
of their message is enhanced by the high returns the process often generates before collapsing.
As a result, even more cautious individuals and firms eventually feel the pressure to participate
(Galbraith 1961; Shiller 2000).
From the vantage point of the financial instability hypothesis, the goal of financial
regulation and supervision should be to detect—and, ultimately, to prevent—financial fragility,
rather than to protect against financial crises (Tymoigne 2010). Focusing on financial fragility
5
Ponzi finance is named after the infamous financier Charles Ponzi, whose pyramid schemes have become
legendary in financial history.
14
implies a change in perspective regarding the proper means to regulate the financial system.
Currently, no regulator dares to touch the profitable institutions at the center of a growing
economic sector; if they do, then they are likely to be quickly challenged. But changing the
viewpoint about what is a “healthy” financial institution would allow regulators to intervene
much earlier. And, more importantly, it would provide them with a solid reason to do so.
Contrary to the current regulatory framework, indicators such as a low or decreasing
default rate, rising net worth, rising business profitability, and dynamic private-sector lending
may not accurately reflect an economy’s underlying health. The case against business profits and
net worth as sources of financial strength has already been described (above). And the fact that
these indicators were the overarching concerns and means of judging health before the Great
Recession was clearly stated by Senator Dodd: “Banks’ regulators were so focused on banks’
profitability, they failed to recognize that loans so clearly unsafe for consumers were also a threat
to the banks’ bottom line” (US Senate 2009a: 2). Defaults are also problematic because low
default rates may be based on looser underwriting practices rather than a robust capacity or
willingness to service debts. This is what was observed during the recent housing boom, when
various unsustainable underwriting practices and securitization techniques allowed banks to
lower debt services for a short time (Tymoigne 2009b). Economic growth is also not necessarily
an indicator of a healthy economy, as will be explained in greater detail below.
In short, one needs to look past the conventional variables of financial robustness. The
key is to see how balance sheets are affected by financial practices, and that requires some
alternative indicators.
Detecting Ponzi Finance
The central concept that defines financial fragility is Ponzi finance, also called interestcapitalization finance. As described above, a common way to define Ponzi finance is that net
cash flow from core economic operations is expected to be insufficient to cover expected income
and capital commitments from financial debts. Economic units differ in their core economic
operations. Some are directly related to income creation (households earn wages, bankers earn
interest, etc.); others are only indirectly related to income creation and rely on dealing in
securities and profiting from fees and capital gains. In the latter case, financial institutions
routinely perform simultaneous purchases and sales of asset positions.
15
Instead of defining Ponzi finance in terms of cash flow, one may also define it in terms of
position-making operations (i.e., from a balance sheet viewpoint). In Ponzi finance, debt is
expected to be covered by growing cash flows from defensive position-making operations (i.e.,
an expected growth of refinancing loans and/or an expected liquidation of asset positions at
growing asset prices). Ponzi finance does not require the existence of a bubble, and measuring
financial fragility is different from detecting asset-price bubbles. It requires only rising prices of
collateral assets or other assets held by the entity involved in the Ponzi process. This condition is
required for cheap refinancing or for asset liquidation at a price that covers debt services. The
main advantage of the balance-sheet definition of Ponzi finance is that its detection does not
require the measurement of cash flows for which data is nonexistent, incomplete, or unreliable.
Instead, one looks at the interaction of debts and asset prices (given a unit’s income level)
through an analysis of underwriting procedures and the type of asset involved.6
Ponzi finance differs from speculation and is not necessarily generated by greed or fraud.
Speculation is defined as taking an asset position with the expectation of making a capital gain
from selling the asset. In a speculative deal, liquidation is a means of making a monetary gain. In
contrast, in a Ponzi process liquidation is a means of servicing financial commitments; it does
not necessarily involve making a gain from liquidation. In fact, people involved in a Ponzi
process may hope that they will never have to liquidate their asset position (at least in net terms)
because this would lead to a collapse of the process.7
To be sure, speculation with borrowed money is a form of Ponzi finance, but Ponzi
processes can be associated with speculative or nonspeculative activities. For example, the recent
mortgage boom was sustained by a Ponzi process that involved prime borrowers who truly
wished to stay in their home (Tymoigne 2009c). Ponzi finance is also different from fraudulent
and abnormal liability practices because some individuals may enter Ponzi processes while
playing by the existing legal rules and following established financial norms. Thus, everybody
may behave “wisely” or “properly” and still contribute to rising financial fragility. Indeed, a
central point of Hyman Minsky’s approach is that lending norms loosen over time and that what
6
Ponzi finance can be described as follows: E(CFPM) = ∆LR + ∆PAQA > 0 and ∆(E(CFPM)/L) > 0, where CFPM is net
cash flow from position making operations, PA is the price of assets, and L is the amount of outstanding liabilities.
Note that Ponzi finance does not require PA be above its “fundamental” value, however defined.
7
Gains for individuals involved in the Ponzi process come from holding the asset (e.g., a home), fees from
managing the scheme, and other monetary and nonmonetary compensation associated with attracting additional
participants.
16
was previously considered a “too risky” funding method may become commonly accepted
(Minsky 1986). However, this change in norms over time does not make Ponzi finance harder to
detect; the Ponzi process is defined independently of those norms.
Some forms of Ponzi finance are more dangerous than others, depending on the way the
economic units involved plan to exit the process. This, in turn, depends heavily on the types of
asset involved. The most dangerous of all Ponzi processes are those for which continuous
liquidation and/or unlimited growth of refinancing are necessary for the process to continue. In
such cases, called pyramid schemes, there is no way to terminate the process besides collapse or
widespread restructuring of financial commitments. This type of Ponzi process usually involves
the funding of assets that do not produce any cash flow from operation (e.g., an owner-occupied
home) or that generates cash flows over which the owner has little or no control (e.g., shares of
companies) and cannot be adjusted to meet the demands of debt service. Examples of those
processes are the mortgage practices of the 2000s and the Madoff scheme (Wray 2007; Kregel
2008; Tymoigne 2009b).
The least dangerous Ponzi financial practices involve the temporary use of growing
refinancing. This usually implies that the economic units involved in the process have some
market power and assumes that the underlying assets are expected to eventually provide
sufficient and reliable net cash flow in the course of unit operations. For example, the
construction of investment goods takes time and must be financed; however, they do not
generate any cash inflow from operation (for the producer and acquirer) until they are finished
and installed in the production process. Thus, a producer’s (and his creditors’) profitability
depends on the capacity to sell the finished product at a high enough price.
In short, detection and measurement of financial fragility should be based on an analysis
of balance sheets (“off balance sheet” items should not exist), cash flow, underwriting, and the
underlying assets. Essential questions include: Is continuous refinancing needed? Is this need
growing relative to outstanding debt? Is underwriting collateral based or income based? Are
rising asset prices needed for this economic process to continue? In exploring these questions,
key financial indicators include the following: the proportion and growth of refinancing loans,
the dynamics of debt and asset prices, and the source and time structure of net cash inflows
relative to cash outflows. For residential housing finance, for example, home price, mortgage
debt, cash-out refinance, and cash-flow margin enable the detection of growing financial fragility
17
(Tymoigne 2010). Minsky (1975) and Campbell and Minsky (1987) used this framework to
develop a framework for banking supervision that heavily relies on cash flows and an analysis of
defensive position-making operations. Recently Hadley and Touhey (2006) at the Federal
Deposit Insurance Corporation have suggested an equivalent approach.
Note that ideally one wants to rely purely on financial indicators to detect fragility; it is
an accounting matter and it is different from discovering the cause of financial fragility. The
point is to understand how economic units finance and fund their economic activity, regardless
of the merits of this activity. Moreover, even if an activity is beneficial to the population in the
short term, its continued existence is difficult to justify when those gains rest on an unsustainable
financial base.
Managing Financial Innovations
Financial innovation is defined as a structural change in the financial sector. This includes the
creation of new financial products, companies, and other business practices, as well as changes
in existing business practices. Given that financial innovations often lead to qualitative changes
in the financial sector, it is important to ensure that current regulations can cope with such
changes. As explained above, financial institutions have a strong incentive to bypass regulations
through innovations, so regulators must keep up with innovations.
Measuring financial fragility is not enough; a regulatory system that seeks to prevent the
growth of financial fragility must keep abreast of financial innovations. In contrast, the
regulatory approach followed in the United States over the past thirty years has allowed financial
market participants to experiment with new innovations and has left those innovations alone as
much as possible. This approach has been shown to lead to catastrophes, and it is at odds with
what goes on in other economic sectors. In consumer products, mechanical tools, medical drugs,
and many other areas, products are made available to customers only after inventions undergo
extensive testing, and new regulations or changes in existing regulations are applied immediately
when a new product enters a market. As a result, new products have been studied in detail so
their properties and potential dangers are fully understood by regulators and shared with the
public. In addition, their use is sometimes limited to a specific segment of the population. It
seems inconceivable that this sort of approach does not also apply to financial innovations.
18
No financial innovation should be left unregulated or unsupervised. History has shown
time and again that, when left unchecked, financial innovations become a fertile ground for the
growth of Ponzi finance and thus financial instability. Stocks, bonds, certificates of deposit,
hedge funds, securitization, CDS, pay-option mortgages, and many others have all ended up
generating financial fragility leading to a financial crisis. While constraining the growth of
financial innovations may have an impact on short-term growth, the evidence link between
financial innovation and long-term economic growth has not been demonstrated.
Take housing as an example. Most of the gains in homeownership were obtained before
securitization; the recent frenzy in interest-only mortgages, CDS, collateralized debt obligations
(CDO), and other exotic loans and securities contributed to an increase U.S. homeownership, but
the gains did not last and the subsequent pain has often been devastating to households and entire
communities. Regulators should have stepped in to slow the growth of homeownership at least a
decade ago because the subsequent run-up was based on unsustainable practices. This would
have involved forbidding or severely constraining the use of many of the era’s hottest financial
innovations.
How to regulate financial practices? If regulators must wait until there is a bubble, then
they will be hard-pressed to determine when to contain particular financial practices. Part of the
problem is that there are many uncertainties regarding what constitutes the fundamental value of
an asset and thus it is difficult to detect a bubble. In addition, since it is hard to get a solid
measure of fundamental value, financial market participants with a strong financial interest in the
continuation of rising asset prices will find ways to justify their position (Galbraith 1961; Shiller
2000). The reticence of regulators to intervene and “remove the punch bowl after the party gets
going” will be even greater when a large part of the population benefits from the continuation of
rising prices and when the underlying financial practices are associated with economic growth.
Indeed, there was even a backlash when Greenspan expressed concerns about irrational
exuberance in 1996; numerous financial market participants, economists, and legislators were
outraged by the suggestion that “the market” might yield improper asset values.
Thus, we need a more solid criterion that is not based on the views of people regarding
the proper asset price level. The concept of Ponzi finance satisfies this criterion. From the point
of view of systemic stability and long-term economic growth, both types of Ponzi finance—
pyramid/collateral-based and production/income-based—are a source of concern because, as
19
long as they exist, the economy is exposed to the risk of debt deflation. At the same time,
banning income-based Ponzi finance may put too heavy a burden on economic growth; therefore,
income-based Ponzi finance may be tolerated in government-insured activities, but should be
strictly regulated and carefully monitored. In addition, financial innovations involving hedge
finance should be promoted, possibly by means of incentives that promote the research and
development of financial products and practices that are safe and that foster sustainable
economic growth.
Collateral-based Ponzi finance should be forbidden in all activities that have an implicit
or explicit government guarantee. It might be tolerated in other economic activities, but even
then regulators should check for potential spillover effects. Collateral-based Ponzi finance
includes a number of recent practices and innovations: compensating loan officers via fee-based
remuneration; introduction of CDO-squared (a security backed by a CDO pool); allowing
pension funds to buy securities backed by toxic collateral; permitting pension funds to participate
in hedge funds’ activities; allowing commercial banks to do proprietary trading directly or
through their affiliates; reliance on level-3 security valuations (based on unobservable data); and
provision of pay-option mortgages to borrowers who cannot make their full debt service
payment.
It is also important to engage in regulatory follow-up after a financial innovation has been
allowed to exist. This is necessary because the use of an innovation often changes over time,
especially as the return obtained from a product starts to decline and financial institutions feel
pressed to find creative ways to keep their profitability on target. An example was securitization,
which was progressively transformed from a hedge process into a Ponzi process (Tymoigne
2009b). One may also cite interest-only mortgages that were given initially only to a very limited
number of prime borrowers and were later extended to all prime and subprime borrowers. Thus,
regulation should be flexible enough to deal with changes in business practices as they come
along. As Campbell and Minsky (1987: 258) write: “Anticipatory vigilance upon the part of the
regulators is required to prevent increased risk exposure. But such vigilance, combined with
intelligence, could contain particular unit risk exposure without the imposition of risk-related
premiums or capital requirements.”
20
Reducing Competition in the Financial Industry
Commercial banking used to be far less complicated. In fact, banking used to be treated much
like a public utility (Kregel 2010). This was made possible by protecting banks and thrifts from
competition and by providing them a reliable and cheap refinancing source through the central
bank.
Thus, a better system of financial regulation requires a vital role for the central bank in
protecting banks and the payment system from competition. The cost of funding should be kept
low and stable; ideally, the short-term policy rates of the central bank should be at zero or at the
very low rate paid on reserves (Wray 2007; Fullwiler 2006, 2009, 2010; Tymoigne 2009a). At
the same time, much more emphasis should be put on the Federal Reserve’s discount window in
order to better grasp changes in the practices of financial institutions and to influence their
business practices (Kregel 1992). This commitment to market protection and to low and stable
refinancing costs has progressively eroded since the 1960s, culminating in the collapse of
savings and loans in the Volcker area (Minsky 1969; Cargill and Garcia 1982).
It might also be useful to reward financial innovations that promote hedge finance by
providing a patent to some financial institutions. Competition in the financial industry is
currently so ferocious that companies have no incentive to spend time creating financial products
that respond to the needs of customers:
We need ‘innovation,’ we were told. We created increasingly
odd products. These obscure structures allowed us to earn higher
margins than the cutthroat vanilla business. The structure
business also provided flow for our trading desks.… New
structures that clients actually wanted were not that easy to
create. Even if somebody came up with something, everybody
learned about it almost instantaneously.… Margins, even on
structured products, plummeted quickly. (Das 2006: 41)
Hall (2009) and Merges (2003) have studied the potential impact of a patent system in the
financial industry, but their goal was to examine whether a patent system would help spur more
innovation. Instead, we need is a patent system that can promote high-quality, reliable financial
innovations—products and practices that fulfill the needs of economic activity while also
promoting hedge finance and helping to ensure sustainable economic activity.
21
Ending “Too Big To Fail” and Making Finance Work for the Economy
When a Ponzi process collapses (as most do), then it should be allowed to unwind. If the
problem spills over to the payment system and government-protected activities, then some
temporary assistance to collateral-based Ponzi processes could be provided to avoid a complete
financial collapse. However, this would only serve as bridge finance while the entire process is
dismantled in an orderly fashion (such as receivership).
For example, some bridge financing should have been provided to Lehman Brothers, but
this should have not prevented closing down the company in an orderly fashion. The same
should have been done with the major banks, hedge funds, and other institutions that recorded
devastating losses in the recent crisis and required more assistance from the government. Many
(either directly or through their affiliates) should have been place in receivership; management
should have been fired and investigated for fraud; assets should have been valued carefully; and
the least costly solution should have been used to deal with the problem institutions (Black
2009). If it is necessary for some institutions to remain “too big to fail,” then nationalization may
be required.
While the United States and United Kingdom are praised for their competitive financial
sector, Wall Street has had only one goal in mind: to maximize shareholder value. Although it is
a largely unsavory world (see, for example, Das [2006]), large numbers of young and talented
individuals are lured toward the financial sector, instead of toward solving social problems, by
the extremely high pay. And in recent decades even nonfinancial companies have moved away
from traditional business operations and toward financial services. As a consequence, in the
United States, the profit share received by the financial sector has gone from about 10 percent in
the mid-1980s to a peak of 45 percent in 2005 (Palley 2007; Crotty 2005).
In recent years, a number of well-known business leaders have suggested it is not healthy
to have a finance-driven economy. For example, Turner expressed his concern before a London
audience as follows:
Not all financial innovation is valuable, not all trading plays a
useful role, and…a bigger financial system is not necessarily a
better one. And, indeed, there are good reasons for believing that
the financial industry, more than any other sector of the
economy, has an ability to generate unnecessary demand for its
own services—that more trading and more financial innovation
22
can under some circumstances create harmful volatility against
which customers have to hedge, creating more demand for
trading liquidity and innovative products; that parts of the
financial services industry have a unique ability to attract to
themselves unnecessarily high returns and create instability
which harms the rest of society.… Yes, financial services form a
vital industry and source of high-skilled employment. Yes, the
City will continue to play a key and vibrant role in the UK
economy. But not everything that a financial system does is
socially useful; and sometimes bits of it can get too big and it
would be better for society if they got smaller. (Turner 2009)
A complementary view is held by Jack Welch, the father of shareholder value (i.e., the
idea that boosting the company’s share price should be a central goal of executives). Welch
stated recently:
On the face of it, shareholder value is the dumbest idea in the
world…shareholder value is a result, not a strategy…. Your
main constituencies are your employees, your customers and
your products.… The idea that shareholder value is a strategy is
insane. It is the product of your combined efforts—from the
management to the employees. (Welch in Guerrera 2009)
High finance needs to be downsized and the original purposes of the banking system need
to be restored. There was a time when investment banks were partnerships that cared about
security underwriting rather than proprietary trading; when commercial banks were of a
manageable size and cared about careful loan underwriting rather than mergers, acquisitions, and
exotic endeavors; and when financial markets provided relatively reliable risk pricing under a
well-regulated and supervised system. It was also an era of widening prosperity and more stable
economic growth. To be sure, we cannot and should not try to turn the clock back to the 1950s or
early 1960s, but we should be willing to admit that the US financial system of that era was in
many ways superior to that of our own, and we should be willing to learn from the past.
Economic Growth and an Investment-led Economy
The challenge of promoting of financial stability extends beyond the matter of appropriate
regulation; it also requires a critical examination of the goal and source of economic growth. The
problem is not just that “growth for the sake of growth” is bad economics. It is also that the
23
widespread emphasis on investment-led growth is highly prone to economic instability for
economic and financial reasons.
One shortcoming of investment-led growth is the traditional Harrod-Domar issue: it is
difficult for aggregate demand to keep up with the additional supply capacities created by
previous investment. This is probably less of a problem in underdeveloped economies where
improvements in standards of living are badly needed (provided, of course, that the capacities of
production are used for internal markets rather than exports to developed countries). But it is
definitely a concern for mature economies. As a result, in the latter case growth should be
refocused on socio-ecologically durable domestic consumption. At the same time, it is important
to avoid the financial dynamics that have been at play in the United States. The United States has
been following a strategy of consumption-led growth for the past thirty years, but it has been
based on unsound financial practices induced in part by growing income inequality.
Another shortcoming of investment-led growth is that it is prone to Ponzi finance.
Minsky (1986) explained in detail how investment was prone to income-based Ponzi finance. As
we observed in the wave of mergers and acquisitions in the 1990s and more recently in the
housing market, investment is also prone to collateral-based Ponzi finance. Indeed, it creates
durable assets that may rise in value, thereby providing an incentive to underwrite loans on the
basis of rising asset prices rather than income (Suzuki 2005; Knutsen and Lie 2002; Black 2005).
While rising collateral-based lending might be fine in financial markets, especially when no
government insurance is provided, it is more dangerous in the case of durable illiquid assets such
as investment goods. Indeed, liquidation is not a viable option to service debt for investment
goods because of the absence of an organized exchange; therefore, any drying out of refinancing
resources will lead to a massive debt-deflation process if collateral-based lending is allowed to
persist for a few years.
It is also important to reexamine the goal of growth regardless of its sources. While
economic growth may help to improve standards of living and to meet population growth, it is
not clear that there is a direct relationship between improved welfare and economic growth,
especially for developed economies. As shown in figure 1, alternative measures to the gross
domestic product, such as the genuine progress indicator, show no significant improvement in
US economic welfare since the mid-1970s. That is because rising socio-economic and
environmental problems have outweighed the gains from increased output.
24
Figure 1. Gross Domestic Product and Genuine Progress Indicator per Capita in the US
(Dollars, Base 2000)
40000
35000
30000
25000
20000
15000
10000
5000
1950
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
0
GDP per capita
GPI per capita
Source: Talberth, Cobb, and Slattery (2007)
Although long-term economic growth may help improve standards of living up to a point,
history shows that market mechanisms push economic units to focus on short-term results and to
preserve short-term economic growth at all costs. As such, “more is always better” when it
comes to quarterly economic growth—even though the underlying financial conditions may be
deteriorating rapidly. Given the current view that places a positive value on any growth in
economic output and profits, it is difficult for regulators or financial market supervisors to find a
reason for action when the economy is growing. In fact, they see an argument to withdraw and
avoid putting “unnecessary barriers” on pursuit of the American Dream.
The goal of long-term sustainable economic growth is laudable as a concept, but what
often happens in practice is a complete disregard for sustainability, not only in financial terms,
but also in socio-ecological terms. There are other means to promote well-being that look beyond
constantly rising production and finding new wants to fulfill. These warrant economists’
increasing attention, not only because the aim of growth with sustainability is often ignored, but
also because the risks to sustainability seem to be rising rapidly.
25
CONCLUSION: THE FUTURE OF FINANCIAL REGULATION
The Great Recession was preceded by decades of financial sector deregulation, reduced
supervision, and a growing belief in self-regulation. Many of those who believed in market
discipline have subsequently reconsidered their framework, but the economic philosophy
underlying the regulatory framework has not changed significantly. Instead of a new regulatory
direction, we now have a patchwork of reforms that have focused on creating new buffers and
marginally increasing existing buffers against future crises. While a new regulatory framework
has been put in place in the US that gives some importance to consumer protection, systemic
risk, and the separation of commercial and investment banking, the framework contains many
loopholes that are easily exploitable. More importantly, the new regulatory framework does not
contain enough flexibility to be able to be proactive in handling regulatory arbitrages and
financial innovations. Finally, the current reform has been discussed with a narrow framework
that puts economic growth at the center of attention.
We need a different type of regulatory framework and a different philosophy of
regulation. At its center must be the detection of financial fragility, which can emerge at any time
but tends to develop and spread in periods of economic prosperity that recorded minor
recessions. The framework should be accompanied by proactive policies that supervise financial
innovations and put in receivership any company, regarding of its size, that is insolvent or on the
verge of insolvency. In fact, a strong supervisory component—including enforcement of law
through prosecution—is needed to ensure that honest and conscientious entrepreneurs have a
chance to prosper.
Experience has shown that high profitability, a low default rate, rising net worth, and
strong economic growth are not good indicators of financial robustness. In fact, these are often
sustained by dangerous, collateral-based Ponzi finance. The goal of regulators should be to
prevent Ponzi finance from emerging and to root it out once detected.
Some worry that this would lead to a much smaller financial system and that economic
growth would be impaired, but the size of today’s financial companies exceeds the needs of even
the largest international nonfinancial corporations; moreover, nonfinancial corporations are now
deeply involved in financial services themselves and community bank lending has been
underpromoted. All this should be reversed. Meanwhile, we should be more concerned about
26
economists’ obsession with economic growth and disregard for the consequences of not
maintaining a sound financial system and protecting economic (and ecological) sustainability.
The recent financial crisis has shown that near-term growth often comes at an extraordinarily
high price.
Promoting financial stability is therefore more than just a matter of financial regulatory
reform. It must also involve a de-emphasis of economic growth and a greater focus on broader
measures of social well-being. And if the underlying economic rules are such that the survival of
economic units forces them not only to rationalize fraud and dangerous financial practices, but
also to overlook the adverse and long-term consequences of their actions, then perhaps the
socioeconomic rules need to be reconsidered as well.
27
REFERENCES
Basel Committee on Banking Supervision. 2010. “The Group of Governors and Heads of
Supervision Reach Broad Agreement on Basel Committee Capital and Liquidity Reform
Package.” Press release July 26. Accessed September 17, 2010 at:
http://www.bis.org/press/p100726.htm.
Best, A.M.. 2007. “Are loan losses high enough in light of recent rising delinquencies?” 2007
U.S. Banking Issue, Special Report, March 26.
Black, W.K. 2005. The Best Way to Rob a Bank Is to Own One: How Corporate Executives and
Politicians Looted the S&L Industry. Austin: University of Texas Press.
_______. 2009. “Those Who Forget the Regulatory Successes of the Past Are Condemned to
Failure.” Economic & Political Weekly 44(13): 80–86.
Blankfein, L.C. 2009. “Do not destroy the essential catalyst of risk.” The Financial Times,
February 9. Accessed September 17, 2010 at: http://www.ft.com/cms/s/0/0a0f1132-f60011dd-a9ed-0000779fd2ac.html
Campbell, C., and H.P. Minsky. 1987. “How to Get Off the Back of a Tiger or, Do Initial
Conditions Constrain Deposit Insurance Reform?” in Federal Reserve Bank of Chicago
(ed.), Proceedings of a Conference on Bank Structure and Competition. Chicago: Federal
Reserve Bank of Chicago.
Cargill, T.F., and G.G. Garcia. 1982. Financial Deregulation and Monetary Control: Historical
Perspective and Impact of the 1980 Act. Stanford: Hoover Institution Press.
Counterparty Risk Management Policy Group III. 2008. Containing Systemic Risk: The Road to
Reform. New York: Counterparty Risk Management Policy Group III.
Crotty, J. 2005. “The Neoliberal Paradox: The Impact of Destructive Product Market
Competition and ‘Modern’ Financial Markets on Nonfinancial Corporation Performance
in the Neoliberal Era.” in G. Epstein (ed.), Financialization and the World Economy.
Northampton: Edward Elgar.
Das, S. 2006. Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of
Derivatives. New York: Prentice Hall.
Department of the Treasury. 2008. Blueprint for a Modernized Financial Regulatory Structure.
Washington, DC: Department of the Treasury.
Fullwiler, S.T. 2006. “Setting interest rates in the modern money era.” Journal of Post Keynesian
Economics 28(3): 495–525.
28
_______. 2009. “The Social Fabric Matrix Approach to Central Bank Operations: An
Application to the Federal Reserve and the Recent Financial Crisis.” in T. Natarajan, W.
Elsner, and S.T. Fullwiller (eds.), Institutional Analysis and Praxis: The Social Fabric
Matrix Approach. New York: Springer.
_______. 2010. “Central bank operation—the general principles.” Forthcoming in B.S. Moore
and L.-P. Rochon (eds.), Post Keynesian Monetary Theory: Horizontalism and
Structuralism Revisited: Reflections and Development. Northampton: Edward Elgar.
Galbraith, J.K. 1961. The Great Crash, 3rd ed. Cambridge, MA: The Riverside Press.
Gallati, R.R. 2003. Risk Management and Capital Adequacy. New York: McGraw Hill.
Geithner, T.F. 2010. “Rebuilding the American Financial System.” Speech at New York
University’s Stern School of Business, August 2. Accessed September 17, 2010 at:
http://www.ustreas.gov/press/releases/tg808.htm
Greenspan, A. 2004. “The mortgage market and consumer debt.” Remarks at America’s
Community Bankers Annual Convention, Washington, DC, October 19. Accessed April 5
2010 at: http://www.federalreserve.gov/boarddocs/speeches/2004/20041019/default.htm.
Guerrera, F. 2009. “Welch denounces corporate obsessions.” Financial Times, March 13.
Accessed on September 17, 2010: at http://www.ft.com/cms/s/0/3ca8ec2e-0f70-11deba10-0000779fd2ac.html
Hadley, K.L., and A.T. Touhey. 2006. “An assessment of traditional liquidity ratios.” FDIC
Outlook Fall: 11–16.
Hall, B.H. 2009. “Business and financial method patents, innovation, and policy.” Working
Paper 14868. Cambridge, MA: National Bureau of Economic Research (NBER).
Hanzimanolis, G. 2006. “Calculated Risk: Assessing Non-Traditional Mortgage Products.”
Prepared testimony on before the Subcommittee on Housing and Transportation and
Subcommittee on Economic Policy Committee on Banking, Housing, and Urban Affairs,
United States Senate, September 20. Senate Hearing 109-1083. Accessed September 17,
2010 at: http://www.access.gpo.gov/congress/senate/senate05sh109.html
Jenkins, P., and B. Masters. 2010. “Financial regulation: The money moves on.” The Financial
Times, September 14. Accessed September 17, 2010 at:
http://www.ft.com/cms/s/0/abf1599e-c02d-11df-b77d-00144feab49a.html
Keynes, J.M. 1936. The General Theory of Employment, Interest and Money. London:
Macmillan.
29
Knutsen, S., and E. Lie. 2002. “Financial fragility, growth strategies and banking failures: The
major Norwegian banks and the banking crisis, 1987–92.” Business History 44(2): 88–
111.
Kregel, J.A. 1992. “Minsky’s ‘two price’ theory of financial instability and monetary policy:
Discounting vs. open market intervention.” in S. Fazzari and D.B. Papadimitriou (eds.),
Financial Conditions and Macroeconomic Performance. Armonk, NY: M.E. Sharpe.
_______. 2006. “Can the Basel revised framework succeed where Basel I failed?” Remarks
prepared for the International Seminar Global Finance and Strategies of Developing
Countries organized by the Institute of Economics University of Campinas, March 13–
14.
_______. 2008. “Minsky’s cushions of safety: Systemic risk and the crisis in the U.S. subprime
mortgage market.” Public Policy Brief 93. Annandale-on-Hudson, NY: Levy Economics
Institute of Bard College.
_______. 2010. “No going back: Why we cannot restore Glass-Steagal’s segregation of banking
and finance.” Public Policy Brief 107. Annandale-on-Hudson, NY: Levy Economics
Institute of Bard College.
Merges, R.P. 2003. “The Uninvited Guest: Patents on Wall Street.” Research Paper 126.
Berkley, CA: UC Berkeley School of Law, Public Law and Legal Theory.
Minsky, H.P. 1969. “The new uses of monetary powers.” Nebraska Journal of Economics and
Business 8(2): 3–15. Reprinted in H.P. Minsky (ed.). 1982. Can “It” Happen Again?
Armonk, NY: M.E. Sharpe.
_______. 1975. “Suggestions for a cash flow-oriented bank examination.” in Federal Reserve
Bank of Chicago (ed.), Proceedings of a Conference on Bank Structure and Competition.
Chicago: Federal Reserve Bank of Chicago.
_______. 1986. Stabilizing an Unstable Economy. New Haven, CT: Yale University Press.
Mishkin, F.S. 1991. “Asymmetric information and financial crises: A historical perspective.” in
R. G. Hubbard (ed.), Financial Markets and Financial Crises. Chicago: University of
Chicago Press.
Nakamoto, M., and D. Wighton. 2007. “Citigroup chief stays bullish on buy-outs.” Financial
Times, July 9. Assessed September 17, 2010 at: http://www.ft.com/cms/s/0/80e2987a2e50-11dc-821c-0000779fd2ac.html.
30
Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration.
2007. “Statement on subprime mortgage lending.” Federal Register 72(131): 37569–
37575. Accessed September 17, 2010 at: http://edocket.access.gpo.gov/2007/pdf/073316.pdf.
Palley, T.I. 2007. “Financialization: What It Is and Why It Matters.” Working Paper 525.
Annandale-on-Hudson, NY: Levy Economics Institute of Bard College.
Shiller, R. 2000. Irrational Exuberance. Princeton, NJ: Princeton University Press.
Suzuki, Y. 2005. “Uncertainty, financial fragility and monitoring: Will Basle-type pragmatism
resolve the Japanese banking crisis?” Review of Political Economy 17(1): 45–61.
Talberth, J., C. Cobb, and N. Slattery. 2007. The Genuine Progress Indicator 2006: A tool for
sustainable development. Oakland, CA: Redefining Progress.
Taylor, J.B. 2009. Getting off Track: How Government Actions and Interventions Caused,
Prolonged, and Worsened the Financial Crisis. Standford, CA: Hoover Institution Press.
Thomson, J.B. 1991. “Predicting bank failures in the 1980s.” Cleveland Federal Reserve
Economic Review 27(1): 9–20.
Turner, A. 2009. “Mansion House Speech.” The City Banquet, The Mansion House, London,
September 22. Accessed on September 17, 2010 at:
http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0922_at.shtml.
Tymoigne, E. 2009a. Central Banking, Asset Prices and Financial Fragility. London: Routledge.
_______. 2009b. “Securitization, deregulation, economic stability, and financial crisis: Do we
need more of the same type of regulation?” Working Papers 573.1 and 573.2. Annandaleon-Hudson, NY: Levy Economics Institute of Bard College.
_______. 2009c. “The U.S. mortgage crisis: Subprime or systemic?” in G.N. Gregoriou (ed.),
Banking Crisis Handbook. London: Taylor and Francis.
_______. 2010. “Detecting Ponzi Finance: An Evolutionary Approach to the Measure of
Financial Fragility.” Working Paper 605. Annandale-on-Hudson, NY: Levy Economics
Institute of Bard College.
US House of Representatives. 2008. The Financial Crisis and the Role of Federal Regulators.
Preliminary transcript of the hearing of the Committee on Oversight and Government
Reform held October 23. Accessed December 18, 2008 at:
http://oversight.house.gov/images/stories/documents/20081024163819.pdf.
31
US Senate. 2009a. Modernizing The US Financial Regulatory System. Senate Committee on
Banking, Housing, and Urban Affairs, Senate Hearing No. 111-42 held February 4.
Accessed November 3, 2009 at:
http://www.access.gpo.gov/congress/senate/senate05sh111.html
_______. 2009b. Oversight of the Securities and Exchange Commission’s Failure to Identify the
Bernard L. Madoff Ponzi Scheme and How to Improve Sec Performance. Senate
Committee on Banking, Housing, and Urban Affairs, Senate Hearing No. 111-368 held
September 10. Accessed November 3, 2010 at:
http://www.access.gpo.gov/congress/senate/senate05sh111.html
Vikraman, S., and S. Nair. 2010 “India is a very good investment: Lloyd Blankfein, CEO,
Goldman Sachs.” The Economic Times, May 21. Accessed on September 17, 2010 at:
http://economictimes.indiatimes.com/Interviews/articleshow/5955955.cms
Wray, L.R. 2006. “Can Basel II enhance financial stability? A pessimistic view.” Public Policy
Brief No. 84/2006. Annandale-on-Hudson, NY: Levy Economics Institute of Bard
College.
_______. 2007. “A Post Keynesian view of central bank independence, policy targets, and the
rules versus discretion debate.” Journal of Post Keynesian Economics 30(1): 119–141.
32